Structure on Rental Property
- Asset Protection
- Splitting Structure
- Tax Efficiency on Rental Property
- Who Should Be Involved in Set Up the Correct Structure
Risks in business are unforeseen and unexpected. Good structure will help you with some problems that arise over time as they can give you options to deal with business failure and protect yourself.
A well-considered structure should achieve the following benefits:
- Protect your assets from relationship property and creditor’s claims.
- Tax efficiency by offsetting loss against other taxable income rather than locking all loss.
- Prevent cash flow issues to keep you solvent (more discussion can be found in the Cashflow section).
Setting up your structures correctly from the start will give you a peace of mind as you know you are well protected if financial disaster occurs. I use GRA for my own accounting affairs. They specialise in property investing and structuring. In this article, I am going to borrow their structures (also used by myself) as they are bulletproof and I recommend everyone consider these approaches if you invest in properties. At Prosperity Finance, we can also assist you in applying these structure plus good loan structures to help you achieve your financial goals.
In simple terms, asset protection means using a trust to protect your assets and when it comes to financing, also splitting your loan across different lenders and entities so the bank does not hold full control over your affairs.
Let’s go through it with an example. Mr Bob is a self-employed plumber. He and his family have a debt-free family home worth $750k. They are looking to buy an investment property to enjoy a good lifestyle in retirement.
Form an asset protection perspective, the family home should be best protected from the risks of running a plumbing business and property investment by holding it inside a family trust.
They then borrow 20% deposit against family home from Bank A, and then borrow 80% from Bank B in a separate entity (e.g. and LTC company). By doing this way, they insulate the family home from the property investment activities and Bank B does not have control over the debt and security in bank A (splitting banks). A transactional mortgage broker will tell you to borrow 100% from Bank A by putting up both family home and rental property in one bank.
Then when the rental property increases in certain value by way of adding values and/or waiting for organic capital growth over time, Bob’s family can top up loan from the bank B and use it to pay off the 20% deposit borrowed again their family home form Bank A, and their family home can be discharged from Bank A and leaving it safely in the family trust. Please note doing this way is not in your bank’s interests as they want to have all your businesses and maximum security. You will need to have a good broker who understand all this and is willing to take the extra mile to do it for you as it involves more work than simply arranging 100% finance.
Splitting strategy should be applied to lenders, entities, and purpose of the loan. Let’s look at them individually.
The reason for splitting banks as described above is it will protect people from the risks of having bank control over all your assets. Also, you are reactive to lender’s changes in credit policies, interest rate hike, and special attention if stick with one bank. Generally, when you have over 5 rental properties or your loan size is over $2m with one bank, you will be looked after by more senior bankers in the bank. It’s a good thing to have a ‘relationship’ with your bank, but you will be scrutinised on the other hand which may not be a good thing. This is part of a bank’s risk management. If you have your loan spread around different banks, you won’t get this attention, which could be very useful in tough times.
Splitting entities means you only deal with one entity from one bank, as opposed to having multiple entities bank with one bank. If something goes wrong with one entity and you only borrow from one bank, all your borrowings and other entities will be affected. If you structure correctly, avoid cross collateralisation among entities. Please also try to avoid a spouse’s personal guarantee unless the servicing of the loan relies on his or her income.
Splitting banks by purpose – I would keep my family home debt completely separate from business debt, and then group investment properties by cashflow portfolio and growth portfolio and keep them with separate banks. With a cash flow portfolio, I make sure the interest rates are sharp enough to maximum net cash flow. I then use another bank to grow wealth strategically. By doing it this way, I reduce the total loan exposure but yet still max out the equity, therefore borrowing capacity.
Tax Efficiency on Rental Property
First, let’s be clear:
Debt on the family home is not tax deductible as it is for private use.
Debt on rental properties and businesses are tax deductible.
Try to maximise deductible debt and minimise non-deductible debt to achieve tax efficiency. It means paying the debt on your family home down quickly before paying down the debt over rental properties. Also, direct your surplus cash follow to the non-deductible debt over your family home first.
There are other ways to legally minimise tax when you have rental properties. Let’s use an example to illustrate.
One of our clients, Louie, buys a new home and decide to rent out their old home (converting home to a rental property) to help service the new loan. The current property is mortgage free thanks to their parents’ help. However, they must borrow $900k for the purchase of their new home which costs $900k.
The old home has estimated market value of $800k and rental appraisal of $550pw.
The interest on the $900k new debt is not deductible due to the intention of owner-occupied property.
The rent income is $28600 per year base on $550 per week.
Other operating expenses are circa $5500 (council rates $2500, insurance $1000 and maintenance $2000)
Taxable profit of $23100 (=$28600 -$5500) is taxable. At 33% personal tax rate (Louie earns $110k per year gross salary) they must pay $7623 in tax.
However, because they discuss with us before taking action, we suggest them to talk to their accountant and set up a new LTC company and transfer the old home to it. The LCT then borrowed 65% (max LVR for investment property) of the $800k which is $520k, the interest costs at 6% is $31,200 which is tax deductible. Louie still must borrow the remaining $380k against their family trust and that is not deductible, but they are much better off because instead of paying $7623 tax, they now have taxable loss of $8,100 (=$23,100- $31,200). At 33% tax rate, Louie can claim circa $2673 in tax. The difference between the two approaches is $10,296 annually. Please note in this case because Louie’s wife is a full-time homemaker and has no income, the LTC is owned by Louie himself so all loss from rental property investment can be attributed to him to receive a tax refund. If the wife has shares in LTC, then she will not be able to get the tax refunds as she does not have income.
Who Should Be Involved in Set Up the Correct Structure
The challenge of setting up a good structure is that it requires holistic approach by taking into account taxation, legal and financial aspects conjunctively. You really need to have an experts team around you which include accountant, solicitor, and mortgage broker. These professionals who don’t look at the big picture and give poor structuring advice can cause serious consequences for their clients. And all of them should not just consider the current situation but also interested in understanding the future plan as once the structure is in place it’s very expensive to change later and sometimes there is no way to fix it.
We initially approached Connie regarding our home loan refinance because my wife normally worked during daytime but I worked at night shift for 3 days a week. It was not convenient for us to go to bank directly.
Connie went to our house during night time where both of us were available to review our existing home loan and discuss our financial goals. She sorted everything for us with a breeze. We were not only successfully refinanced existing home loan and secured very good interest rates and cash rewards but she also managed to help us finance our first rental property without any cash deposit by leveraging our home equity which we were not aware of before. She also gave us great advice on how to manage our home loan so they can be paid off quicker and build wealth through property investment.
We definitely recommend Connie because her knowledge, experience and expertise in finance gave us peace of mind. She is always there to help us and keep us updated regarding our home loans.